Opinions and views in these papers are those expressed
by the author(s). They are not to be taken as expressions of support for
particular positions by the Department of Labor. Please do not cite these
papers without prior permission of the author(s).

AN OVERVIEW OF ECONOMIC, SOCIAL,
AND DEMOGRAPHIC TRENDS AFFECTING THE US LABOR MARKET

Robert I. Lerman Stefanie R. Schmidt The Urban
Institute

V. Adapting to Tight Labor Markets

With the U.S. economy reaching the lowest unemployment rates in 30 years
and the employed share of the adult population at an all-time high,
todays primary concerns are labor shortages and inflationary pressures
resulting from tight labor markets. According to many predictions, the
1995-1996 unemployment rates of 5.5 percent should have already led to
excessive wage growth. In a recent estimate, Akerlof, Dickens, and Perry (1996)
concluded that the rate of unemployment consistent with no increases in the
inflation rate was in the 5.5-6.0 percent range. The U.S. experience of 1997
and 1998 cast doubt on these and similar projections. Even after reaching 4.5
percent unemployment rates, the U.S. economy has yet to experience inflationary
wage pressures.

How have these pressures been averted? Are they about to arise shortly?
How are employers coping with the tight job markets? Is rapid wage growth
taking place in the lowest unemployment rate areas? To what extent have new
workers been drawn into the job market to mitigate shortages and wage
pressures? What mechanisms other than wage increases are employers using to
recruit and retain workers? Are employers turning to low-turnover strategies
with job ladders and extensive training? To what extent are employers able to
lower their formal job qualifications in response to a shortage of workers?

The National Trends

The impact of the 1990s expansion on the labor market is unusual in two
respects. First, the absence of any observable wage pressure in the context of
a 4.5 percent unemployment rate is unexpected. Figure 1 graphs the trend in
unemployment with the trend in the Employment Cost Index (ECI), which best
captures the potential inflationary pressures emerging from the labor market,
and the Consumer Price Index (CPI). Note that from 1986 to 1989, when
unemployment rates fell from 7.0 percent to 5.3 percent, the ECI rose from a
growth rate of 0.7 percent per year to 1.2 percent per year and the CPI doubled
from 2 percent to 4 percent per year. Yet, in the 1990s, even larger reductions
in the unemployment rate have induced no increase at all in the ECI or CPI.
Second, the dramatic reduction in unemployment rates has stimulated only a
modest

impact on participation in the job market. Note that in
Figure 2 falling unemployment in the late 1970s and mid-
to late 1980s attracted many new workers into the market, raising participation
rates 1.5 to 2 percentage points. In contrast, the decline in the 1990s to 4.5
percent unemployment rates has only led to a 0.7-point increase in
participation. Thus, large increases in labor supply cannot explain the limited
impact on wages and prices.

One feature of the current expansion that follows past patterns is that
the expansion has raised employment most among the more disadvantaged groups.
Table 6 reveals that the percentage-point gains in
employment-population ratios and declines in unemployment rates were
substantially higher among minorities, teenagers, and less-educated workers
than among prime-age males. For example, the unemployment rate among black men,
ages 20 and over, fell an extraordinary 7 percentage points, from almost 16
percent to about 9 percent. White men, ages 20 and over, also experienced
sizable reductions in unemployment rates, but virtually no movement in
employment. Similarly, the unemployment rate of college graduates declined from
3.2 percent in 1992 to 1.7 percent in 1998, while the employment-population
ratio of college graduates remained constant at 78 percent.

With the economy apparently running out of skilled workers, since nearly
all were already employed earlier in the business cycle, employers must turn to
less-qualified workers to fill the new job. These pressures are good for the
disadvantagedfirms are more willing to take inexperienced, less educated
workers; to expand training; and to lower hiring standards. But shortages of
high-skilled workers could lead to inflationary wage increases, while adding
low-skilled workers could lower productivity and raise costs.

Firms might have to alter their production
approaches to the extent that the mix of skills

among new workers differs sharply from the mix among existing workers.
Employers would seem to face serious problems integrating large numbers of
less-skilled workers into their organizations, particularly at a time when the
demand for skill is increasing on a long-run basis.

Surprisingly, a close look at the data provides an entirely different
picture of recent job market trends. As Table 7 reveals,
fully 94 percent of the 11.7 million newly employed adult workers (ages 25 and
over) had at least some college or a BA degree and over half of them came from
the highest educational category. Demographics and educational distributions by
age allow us to reconcile the substantial improvement in the position of
less-educated workers with the high levels of education among the newly
employed. The normal tendency at peaks in the business cycle for employers to
draw on less-educated workers has been offset by the long-term increase in the
educational status of the population.

While the typical dropout had a much easier time finding a job in 1998
than in 1992, dropouts did not account for any of the growth in employment. The
reason was that the high school dropout population declined by 2.8 million, as
the number of young high school dropouts becoming adults was smaller than the
number of older dropouts dying. At the same time, while the typical adult
college graduate was no more likely to be employed in 1998, the population of
college graduates ages 25 and over increased by about 7.5 million, or 20percent, well above the 7 percent growth in the total adult population. As
a result, college graduates constituted 65percent of the 11.5 million
increase in the 25-and-over population.

Thus, the striking reality is that employers have been able to draw on a
growing pool of highly educated workers, even over the 1992-98 expansion.
Despite the fact that nearly all college graduates looking for work had jobs in
1992, the 20 percent increase in the population of

college graduates, ages 25 and over, provided a substantial pool of new
educated workers. While the 25-and-over population has increased by 7 percent
since 1992, the numbers with at least some college jumped by 18percent.

These surprising figures put to rest a worker mix
explanation for limited wage growth. Had the mix of workers become less
educated, this compositional factor would have exerted a downward impact on
average wages. Put another way, increased wages among existing workers could
have been offset by a rising share of low-wage workers. In fact, the opposite
took place. The average educational level of the workforce increased
considerably over the period, thereby increasing average wage growth above the
growth in wages among individual groups.

The rapid expansion in the supply of college-educated workers may
explain why worker shortages have not become so widespread as to stimulate wage
inflation. The long-term trend toward a rising demand for skilled and educated
workers continued over the current expansion. In recent years, the structure of
occupations has shifted dramatically toward high-skill positions. Professional,
managerial, and technical jobs account for nearly two-thirds of the net
growth in employment, far above the 28 percent of jobs in these occupations in
1988. Despite the shift toward high-skill occupations and the increased demand
for skill within occupations, the substantial growth in the supply of the
college-educated population apparently provided enough of an inflow to prevent
the types of shortages one would expect at this stage of the business cycle.

Area Variation in Unemployment Rates and Wage Pressures

The national picture captures the average market conditions for the
nation but does not show the variation across labor markets in the degree of
tightness and any induced pressures on wages. In Figure 3, we can see the wide
variation in unemployment rates, ranging from about 3 percent in the 10 states
with the lowest unemployment to almost 6 percent for the 10 with the highest
unemployment. Fully half (25) the states had unemployment rates at 4 percent or
below and only 5 states at about 6 percent or higher. Growth in employment is a
second indicator of labor market tightness in an area. Figure 3 displays
percentage employment change between the first quarter of 1995 and the first
quarter of 1998, when employment in the nation rose by about 5.5 percent. It is
striking that high employment gains did not necessarily go with low
unemployment rates. In fact, the correlation between unemployment rates and
percent growth in employment was slightly positive at .05.

The wide variations across states might provide indications as to
whether inflationary wage pressures are finally emerging from tight labor
markets. After all, 15 states now are experiencing unemployment rates at about
3.5 percent or below. If migration is limited, one would expect to observe
faster wage growth in these low unemployment rate areas than in high
unemployment areas.

To test this possibility, we compiled data on nominal wage growth
between 1995:I and 1998:I by state and calculated growth in average weekly and
average hourly wages and salaries from the outgoing rotation samples of the
relevant Current Population Surveys. Next we tabulated growth in earnings by
states ranked on the basis of 1998 unemployment rates, 1995-1998 percentage
change in employment, and 1995-1998 percentage change in unemployment rates.
The calculations grouped areas by quartiles of each labor market indicator. The
unemployment rate groupings were those at 3.7 percent or below, 3.7 to 4.7
percent, 4.7 to 5.1 percent, and over 5.1 percent.

The well-known Phillips curve relates wage growth to levels of
unemployment rates. Looking at this relationship across areas, one finds that
wage growth was no higher in the lowest unemployment areas than in other areas.
The numbers in Table 8 show no apparent relationship
between rates of wage growth and area employment conditions. For example, the
mean wage rates and mean weekly earnings were virtually identical across all
four quartiles of unemployment rates.

Employer Responses to Tight Job Markets

How have employers kept wages in check in the face of these extremely
tight labor markets? The answer is unclear. However, two sets of strategies
appear to have emerged. The first is common to expansions and involves widening
recruitment, expanding training, upgrading

existing workers, and/or lowering normal hiring standards. The second
involves the use of signing bonuses, stock options, profit-sharing, and other
forms of non-wage compensation.

Types of Employer Responses

Employers engage in a number of strategies in response to a shortage of
workers. Among the most common are:

To increase recruiting, by advertising more, turning more to
employment agencies, reaching a wider geographic area, and even paying
recruiting bonuses to employees;

To increase overtime work and turn part-time positions into
full-time jobs;

To reduce education and other requirements for new hires;

To restructure work in ways that adapt to the available workforce;

To substitute capital for labor;

To expand the supply of qualified workers by conducting additional
training;

To improve working conditions;

To offer bonuses, stock options, and other forms of non-wage
compensation to new and/or existing employees; and

To improve wages and fringe benefits.

Although employers generally turn to increases in wages and fringe
benefits only as a last resort, a significant impact on wages usually emerges
by this point in the business cycle. A natural explanation is that employers
are choosing to emphasize responses other than wage increases over the current
expansion. While the evidence concerning non-wage responses is spotty,
individual cases and limited data suggest employers are indeed adopting the
strategy of emphasizing non-wage approaches.

Training

Employers are apparently increasing their training in a number of ways.
Unfortunately, there are few consistent data sets documenting training
practices over time. The 1994 National Employer Survey (NES) of over 4,000
employers, conducted by the U.S. Bureau of the Census on behalf of the National
Center on the Educational Quality of the Workforce, University of Pennsylvania,
gives a detailed picture of training patterns and expectations for growth over
time. One striking finding is that over two-thirds of employers reported that
the skills required to perform production or support jobs increased over the
prior three years. Over three out of four employers said they had increased
training outlays over the prior three years, while only about 3 percent or less
had decreased their amounts of training. Employers reporting rising skill
requirements on production and support jobs were especially likely to have
increased training; 85 percent of this group increased training compared to 58
percent of employers who said skill requirements had not increased. In
addition, the majority of employers projected a further increase in training.

Of the employers reporting an increase in training, over 80 percent
cited changes in the work process, such as changes in technology or changes in
the structure of work. Over 60 percent attributed the increases to product
changes, and 90 percent saw expanded training as a way of upgrading quality. In
addition, nearly two-thirds of employers indicated that increased training was
motivated by the fact that new hires did not have the necessary skills.

The 1994 NES reveals that several types of training are offered by large
proportions of employers (see Table 6). Note that over
three in four employers reimburse workers for tuition at colleges and training
institutes and that over 70 percent provide training in production equipment,
computer literacy, cross training, and teamwork. Most of these training areas
are expected to grow over the next three years.

A Department of Labor survey (Frazis et al., 1998) undertaken in 1995
showed that 70 percent of workers received some formal training in 1995 and
virtually all (96 percent) spent time in informal training. Formal training is
training that is planned in advance and has a structured format and a defined
curriculum. Much of the formal, employer-sponsored training involved only a
modest number of hours.(1) Employees reported averaging only about 13 hours of
formal training during a six-month period and about 31 hours of informal
training. Reports by employers showed an even lower number of hours. Still, the
costs of training, counting wages and salaries paid to trainees, tuition
reimbursements, wages of trainers, and payments to outside trainers, amounted
to over $50 billion per year. The youngest (under age 25) and oldest (over age
54) workers experienced the least amount of training. Smaller firms provided
somewhat less training, though few differences were observed between
medium-size establishments (100-499 employees) and large establishments (500
and over employees). Firms implementing four or more new workplace practices,
such as pay for skills, employee involvement in technology decisions, job
redesign, quality circles, and self-directed work teams, reported almost twice
as much formal training as other firms. Formal training varies significantly
among types of workers. More training reaches the high-paid, well-educated,
full-time workers, workers in establishments with medium or low turnover, and
workers with long tenure at the firm. For example, 90 percent of workers with a
BA or more received formal training, but only 60 percent of those with a high
school degree or less did so. At the same time, average hours of training were
higher among workers in the production, construction, and material handling
occupations than among managers.

These BLS data contrast sharply with data reported by the OECD from the
International Literacy Survey. Their report suggests only about 23 percent of
workers received any job- or career-related training paid for by employers.

In any event, there is little indication that firms are providing depth
in their formal training sufficient to raise significantly the capacities of
less-skilled workers. Formal training averages less than one week per year.
Despite these limitations, some firms are increasingly emphasizing training,
not only to improve the productivity of existing employees but also to increase
the supply of qualified workers in various fields.

Many companies have begun working with high schools to develop a new
workforce.

Charles Schwab is a good example of a company making an effort to shift
from recruiting only workers with a BA degree to developing its own workforce
through a combination of work-based learning, work experience, and school-based
learning. CISCO Systems is working with high schools to help young people
qualify for jobs as computer network administrators. The auto industry has
promoted a variety of programs to upgrade the quality of training for future
auto mechanics. Other industries are working closely with career academies,
which focus on industry or occupational fields in such areas as finance,
travel, health, and computers.

Apparently, the involvement of employers goes beyond a few individual
cases. According to the 1997 follow-up of the National Employer Survey of about
7,000 employers, an extraordinary 74 percent said they were participating in
school-to-work partnerships and nearly 24 percent reported providing
internships.

It will take time before many of these initiatives generate a
substantial increase in the labor supply of skilled workers. However, in the
interim, hiring and training young people as low-wage interns may allow many
firms to limit the costs of expanding their workforce.

Several important questions arise about training responses. First, to
what extent do firms perceive special barriers that limit the amounts of
training they sponsor? Some firms may hold back on extensive training efforts
because of their concern that workers will leave the firm once they undergo
training. Second, can we learn anything about the nature of worker shortages
from the training undertaken by firms?

Non-wage Forms of Compensation

Employers are apparently expanding their use of special forms of
compensation that do not involve direct salary increases. Despite the thriving
economy, firms see themselves in a highly competitive environment, one in which
raising prices can mean large losses of sales.

Anecdotal evidence suggests firms are turning to bonuses and variable
compensation as a way of attracting workers in todays tight labor market.
According to Louis Uchitelle (1998), signing bonuses are proliferating and
reaching well beyond upper-level managers and skilled technicians. He cites
examples such as the Labor Departments offer of a $4,000 bonus to attract
young economists and Price Waterhouses hiring bonus of $10,000 provided
to newly hired management. Reportedly, the 1998 class of Cornell MBAs received
an average bonus of $17,500, nearly double the 1996 average of $9,400.
Increasingly, employers are willing to extend signing bonuses to other college
graduates, including public school teachers.

A second expanding source of compensation is employee stock ownership
and stock options. According to the 1994 National Employer Survey, 35 percent
of employers were offering stock options to their workers. By 1999, the figure
is no doubt considerably higher. The National Center for Employee Ownership
estimates that nearly 8 million workers participate in employee stock ownership
plans or stock bonus plans and at least 6 million are in broad stock option
plans. Changes over time in the compensation provided through these and other
stock option or stock purchase plans are unknown. The Bureau of Labor
Statistics does not try to measure the implicit income provided to workers who
receive stock options.

One related trend in compensation is the area of nonproduction bonuses.
According to Schwenk (1997a,b), the proportion of compensation going to
nonproduction bonuses nearly doubled, rising from about 0.7 percent in 1986 to
1.3 percent in 1996. As expected, year-to-year percentage changes in
nonproduction bonuses are highly variable and presumably highly sensitive to
the profits of firms paying such bonuses (Walker and Bergman, 1998). For
example, since the 1991-92 period, percent changes in bonuses were 16 percent,
21 percent, 7 percent, 14 percent, and 5 percent.

The share of wages and salaries in total compensation seems to have
declined only slightly, from 73 percent in 1986 to 71.9 percent in 1996, if we
take account of bonuses and benefit costs, including paid vacations, sick
leave, health insurance, retirement plans, and social security and
workers compensation. However, these data ignore the value of stock
options and possibly other types of special payments.

Whatever the facts, should policymakers promote compensation schemes
linked to a firms performance? Might the apparent increases in bonuses
and stock options help firms remain cost-conscious in todays highly
competitive environment? In the early 1980s, Martin Weitzman (1984) proposed
the share economy, one in which compensation would be based less on
fixed-wage contracts and based more on arrangements in which what workers
received depended on the firms revenues or profits. Through the 1990s,
Weitzman has continued to make the case for moving away from fixed wages, and
his work has stimulated a lively debate in the economics profession. The debate
deals with issues involving microeconomics (relating to the impact on
individual firm hiring and performance) and macroeconomics (relating to
aggregate unemployment and inflation).

Research on the role of pay incentives in firm performance certainly
predates the work by Weitzman. A substantial literature has developed around
these issues, and many of the findings suggest positive impacts on productivity
and profitability from shifting compensation away from fixed-wage contracts.

The focus here is on whether variable pay helps firms respond to booming
macroeconomic conditions. Although Weitzmans primary argument was that
variable pay could induce hiring and reduce the 1980s problem of stagflation,
he (1988) subsequently argued that the shift to variable pay could lower NAIRU,
the unemployment rate consistent with non-increasing inflation. Two key
elements of the argument are 1) that incentive pay arrangements encourage firms
to increase hiring, and 2) that increased flexibility in pay will permit
reduced variability in employment. In the case of pure wage contracts, firms
hire to the point where the marginal cost (the wage) of the extra worker is
equal to the marginal revenue obtained from the extra workers
contribution to sales. In this case, if sales or prices fall and thus reduce
marginal revenue below the wage costs, then the profit-making firm is likely to
lay off workers until it reaches a new equilibrium. On the other hand, if
workers were to receive a percentage of sales, then the firm would have no
incentive to lay off marginal workers so long as they contributed some amount
to revenues (even if it were less than the wage or the average revenue per
worker).

Overall revenue to the firm would have declined but the firm would
continue to offer employment to existing workers, since the revenues generated
by the marginal workers would benefit the firm. However, average pay to the
remaining workers would be lower with a no-layoff policy than with the types of
layoffs arising in firms with wage contracts.

One obvious implication is that workers might be able to gain increased
employment stability but at the cost of increased variability of compensation.
Workers confident in their ability to keep a job might well choose to avoid the
risks of variable pay. On the other hand, workers vulnerable to layoff and
workers optimistic about their firms future are likely to prefer
compensation linked to their firms performance.

Notwithstanding the logic of the share economy, the advantages of an
increased emphasis on profit-sharing or revenue-sharing might be illusory
(John, 1991). In a profit-sharing firm, adverse shocks reduce profits and thus
lower compensation per worker. Although firms have no direct incentive to lay
off workers in this situation, they may be reluctant to allow average worker
compensation to fall significantly. They may lose their best workers to
competitors or may find that their jobs do not pay enough to deter workers from
shirking. To avoid this scenario, firms may lay off workers even though the
marginal workers do not generate any direct costs. Another possibility is that
reduced compensation will lower the supply of labor and again induce reductions
in employment in response to the shock to profits. Thus, while some labor
market conditions suggest little gain from the shift away from fixed-wage
contracts, other scenarios indicate more employment stability.

In todays context, the more important question may well be the
impact of profit-sharing schemes on NAIRU. Here, Weitzman (1988) sees some
potential gains for the share economy but concedes that some causes of a high
natural rate of unemployment would apply as much in a profit-sharing context as
in a fixed-wage context. Neither would have any advantage if high NAIRUs
resulted from high social benefits, excessive bargaining power by unions, or
efficiency wages. However, if the problem was that firm insiders were so
powerful that external unemployment did little to affect wages, then bias
toward expanding employment in profit-sharing firms would help speed up
reductions in unemployment when the economy expanded. A world emphasizing
profit-sharing might also reduce frictional and structural unemployment.

Surprisingly, Weitzman says little about the potential impact on
inflation or on how uncertainty on the part of the firm will affect employment
and prices in a low-unemployment economy. Firms concerned about raising prices
and uncertain about future sales may wish to avoid building high wages into
their permanent cost structure. At the same time, they must recruit workers in
the context of a tight labor market. The response by many firms is to try to
make one-time payments, especially to newly hired workers, and to offer stock
options and bonuses that will ultimately be linked to profits. To the extent
firms can attract and retain the same quality of workers using these
compensation schemesperhaps because good workers are willing to take
risks in return for high potential rewardsthe package may make financial
sense as a hedge for firms. Since payments to workers will be directly
correlated with the firms performance, the losses due to weak firm
performance will be mitigated by the lower compensation to workers, while gains
due to strong firm performance will be moderated by the higher compensation
going to workers.

Already, the government encourages profit-sharing in a number of ways.
There are special rules that provide tax advantages to workers and firms who
create Employee Stock Ownership Plans (ESOPs). The tax treatment of stock
options is also favorable. A worker receiving an option to buy his
companys stock at the current market price obtains something of value
even when the option price is the current market price. Modern financial
economics can place a value on these options. Yet, workers will not pay any tax
on the options until and unless they exercise the options and sell the stock at
a price higher than the option price. A key question is whether the government
should do more to encourage these and other profit-sharing arrangements.